How to Use TIPS to Calculate Inflation Expectations
Using the Treasury Inflation-Protected Securities Formula
What Are TIPS?
Like a plain-vanilla Treasury note, TIPS provide investors with a fixed-rate yield with interest paid semi-annually. The key difference: the principal of TIPS is adjusted to reflect the change in the Consumer Price Index (CPI), and the interest payment is then calculated using the adjusted value of the bond. This payment increases with inflation, but it would decrease in the rare case of deflation (i.e., falling prices). The amount of principal an investor receives is her original investment plus any upward adjustment. In short, the principal rises with the CPI, while the coupon rate represents the investor’s “real return,” or return above inflation.
In comparison, plain-vanilla Treasuries carry no such inflation protection. Since a Treasuries investor is fully exposed to the impact of inflation on the underlying bond, he or she demands a premium, or a higher interest rate, which can be thought of as “protection” against inflation.
Calculating Inflation Expectations with TIPS
This risk premium can be calculated by comparing the difference in yields on a Treasury and a Treasury Inflation-Protected Security (TIPS) of similar maturity. The result indicates the amount of protection investors require, which in turn tells us what inflation expectations may be. For example, if the five-year Treasury has a yield of 3 percent and the five-year TIPS has a yield of 1 percent, then inflation expectations for the next five years are roughly 2 percent per year. Similarly, using two- or ten-year issues would tell us the expectation for those periods. This difference is often referred to as the “breakeven” inflation rate.
Another way to look at the equation is:
Treasury Yield = TIPS Yield + Expected Inflation
We can therefore easily find the market’s expectation for the future inflation rate, at least in theory. The reason this is only “in theory” is because the differences between the two securities lead to market distortions that prevent this calculation from providing an exact result. TIPS’ trading volume is much lower than that of Treasuries, so the yield differential can often change due to technical factors not having to do with inflation expectations. As a result, the yield gap can be used as a guide but not as an absolute measure of current expectations.
ETFs That Track Inflation Expectations
Investors can actually trade inflation expectations since this exchange-traded fund (ETF) tracks the gap between 10-year Treasuries and 10-year TIPS:
- ProShares Inflation Expectations ETF (RINF): Tracks the TIPS-Treasury spread with no leverage. The share price of this fund should rise when expectations go up.
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